Question

Explain the time value of money concept. What is meant by the effective interest rate. How are time value of money concepts applied to accounting applications in determining the present value of expected cash flows and in valuing bonds?

Answer 1

1) Time Value of Money in simple terms, money received today is not equal to the money receivable in the future (same amount) due to inflation, purchasing power etc.,

2) Effective interest rate refers to the rate which is used to bring future value cash flows to present value and present value cash flows to future value. Or in other terms, it is the rate at which one earns or pays over a period of time due to compounding.

3) Time value of money concept is very much useful in accounting applications in order to accept or reject the given project using IRR or NPV Techniques.

4) In valuation of bonds, time value of money is useful to calculate present value of future cash flows that are going to be received, so that one can decide whether purchase of bonds at the given price is financially viable.